(By the way, if you’re feeling superior and taking comfort that Europe will go first off the cliff, Kotlikoff disagrees. Europe’s debts are larger, but their social programs are better funded, so their fiscal gaps are much lower than ours. The winner, it turns out, is Italy with a negative fiscal gap. Answering the obvious question, Kotlikoff offers

“What explains Italy’s negative fiscal gap? The answer is tight projected control of government- paid health expenditures plus two major pension reforms that have reduced future pension benefits by close to 40 percent.”Don’t get sick or old in Italy, but perhaps buying their bonds is not such a bad idea.)

I am a bit skeptical of that claim; so I decided to check with God, er . . . I mean I decided to check with the ultimate arbiter of truth, the asset markets:

As you can see, Italian 10-year bonds offer considerably higher yields than German, French and Dutch bonds, and even higher yields than Spanish bonds. Italy has a massive public debt (third largest in the world), an economy that has shown almost no growth since 2000, and a very dysfunctional political system (which the voters recently decided not to reform.)

I greatly respect Kotlikoff, and even more so John Cochrane. But I respect the markets far more than any mere mortal. So unlike Kotlikoff and Cochrane, I remain relatively pessimistic about the Italian debt situation.

PS. I am back from 5 days in Turks and Caicos (is there a law in the Caribbean mandating nothing but Bob Marley music at resorts?), and I am starting to get caught up.

My guardrails post is intended to address tiresome criticism of NGDP targeting by people who have never bothered to actually read what I have written on the topic. No, neither the current lack of interest in NGDP futures trading nor the risk of market manipulation pose any kind of problem for the system I am actually advocating. (Unless you believe, “Bretton Woods could not possibly have worked because speculators would have manipulated the market.”)

I think Kotlikoff is going under CBO rules: assume that the current laws will stay valid forever.

However, the market understands that France not having reformed its pension system is actually a form of policy capital: they can still reform and save money, whilst Italy has already cashed in (naturally, the earlier you cash in the more that capital is worth).

MELBOURNE — Like many of her peers, Megan Shellie doubts that she will ever be able to buy a home within a reasonable commuting distance of a job in one of the teeming coastal cities that drive Australia’s economy.
Even though she expects to be earning a salary of up to 60,000 Australian dollars ($45,000) after graduating from university in June, the 23-year-old is despondent about a market in which property prices seem increasingly out of reach of average wage-earners.”

—30—

Same thing in Great Britain reports Tyler Cowen. In the 1990s a Brit could buy a house. No more.

Given the deeply embedded system of property zoning in Australia, Great Britain and the U.S., is it not time for a frank discussion of trade deficits and booming house prices?

Tokyo has very affordable housing,they are back to running trade surpluses.

Tokyo as an example for affordable housing? Are you kidding?

I don’t see the connection between trade deficits and housing.

In Germany for example people complain about housing prices as well. I assume the problem is mostly zoning and regulation. On the other hand a lot of (if not most) people who are complaining so much about exploding housing prices are also complaining that there is not enough zoning and regulation.

‘Italy’s social security reform efforts indicate significant progress toward alleviating risks to the long-term sustainability of public finances due to population aging. Yet, we expect that the country’s budgetary outlook will remain challenged, given the modest near-term economic growth outlook and the absence of a resolute reduction in the budget deficit and government debt.’

—————quote————
According to Eurostat population projections, the old-age dependency ratio in Italy will rise to 52.9% in 2050 from 32.8% in 2015 (see table below; the old-age dependency ratio is the number of people 65 and older divided by the number of those 15 to 64). Even now, Italy has one of the highest old-age dependency ratios in our sample, second only to Japan (43.3% in 2015) and just ahead of Germany (31.8%) and Greece (31.2%). Overall, we project that the total population will grow over the coming decades, but that growth will slow down in the early 2040s, reaching 67 million in 2050. We forecast that the share of working age population in total population will fall to 56.5% by 2050 from the current 64.8%.’

…. We think that, as is currently the case, the bulk of Italy’s age-related spending will go toward pension outlays, followed by health care, representing 14.8% and 6.8% of GDP, respectively, by 2050. However, contrary to the dynamics in pension spending, which we see declining toward the end of the projection period, we expect health-care expenditures to increase at a gradual but moderate pace throughout the period.

These dynamics suggest a gradual deterioration in Italy’s budgetary position in the long term. If unmanaged, the weight of general government spending–including social security–could rise as age-related spending increases, coupled with a rising interest bill as deficits and debt mount. Our analysis suggests that, without further fiscal or structural policy reforms, Italy’s net debt could rise to 138% of GDP by 2050, slightly higher than the sample median, which stands at 134% of GDP. Nevertheless, the respective projected increases in Italy and the 58-country median, indicate that future budgetary challenges emanating from population aging in Italy appear comparatively much less pronounced than for the average sovereign included in our analysis.
———-endquote————–

I believe that current US Social Security law actually does balance taxes and spending. It would cause a huge uproar, so I’m not saying it’s no issue. But I’m somewhat certain that once the trust fund is empty, benefits are automatically reduced by whatever percentage necessary to match inflows and outflows. Again, I’m just saying that as a technical matter and even on the technical matter I could be mistaken.

Scott, I’m not saying it’s not a market, in a broader sense everything is a market. But what kind of market is it? The ECB seems to be a huge player in this market, maybe even quasi-government or very similar to it, with relevant interventions, that sometimes look more like open heart surgery. Not to mention they buy private bonds, too. So what do you expect in a market with interventions like this? Distortions maybe?

And what kind of market is this anyhow when it needs interventions like this? It seems to be an insufficent market, an insufficient system, a system that needs something like market monetarism very badly, so that all those interventions are not needed in the first place.

ECB has limits on each bond issuance and they are buying corporate AAA precisely to minimize the distortions. Moreover they are buying up the bonds more or less evenly and credit risk is given by interest rate spreads not by the absolute levels of interest.

And Scott is a bit myopic here, Italian yields are higher because of the upcoming snap-election that may create the real political and geopolitical upset(and the risk there is much bigger than Le Pen was, establishment is polling extremely weak and that’s general elections). Couple months ago you had Italian 10yr at 1.15% Does that mean their debt was more sustainable than US debt? Barely…

“George, You can’t compare Italian and US yields, they are in different currencies.”

That’s exactly the point… Though in this case long run inflation differentials are not that big. Anyhow sustainability is about the current and projected primary budget surplus relative to (r-n)*(Total Debt/NGDP). r is the nominal rate of interest and n is NGDP growth rate. Looking solely at the interest rate is misleading, that was my point.

Just one example from Italy according to German media: Their biggest airline Alitalia. Deep in the red since at least four years, burning one million euros every single day. Today the employees voted down a cost-cutting plan. Why? Because the employees are expecting that the Italian government will save them again, as so many times before, costing Italian (and European) taxpayers just one billion euros so far.

A question that comes to mind is, are 10-year bond yields really a good measure of the expected scope of a fiscal crisis projected to arrive 20-40 years from now?

E.g., here in the USA the long-term debt course is clearly unsustainable (as CBO has been emphasizing for years) but bonds have very low yields as there is no question about the government’s ability to service them for the next 20 years or so. Why should current bond prices reflect events expected to occur only well after the bonds mature?

ISTM these prices much more reflect expected conditions over the next seven years or so than those expected to arrive 25 years from now.

The US can always meet its obligations because it prints its own currency so 50 year rates would be low too. Italy needs to borrow from the markets, which can demand higher rates since Italy can’t print its currency to meet its obligations. So the market knows the US isn’t revenue constrained while Italy is. That’s why Italy’s rates are higher. Honestly, do we think the US will ever be able to tax and grow enough to meet its current debt? No way, it’s already too big, yet rates are still low. Because there is no risk of non payment.

The US can always meet its obligations because it prints its own currency so 50 year rates would be low too.

Printing money to carry otherwise unsustainable debt creates inflation. In the late 1970s the government printed money, created inflation, yields on US debt rose into double-digits, and the price of long US Treasuries fell by near half.

like UK and Switzerland. Though they perhaps happened to be there par hasard and were not mentioned in the text, I admit. Still most of Italian premium seems to be related to redenomination risk rather than default risk.

@George
I think Scott answered your last point already:
Re-denomination is just a fancy word for default.

I agree with Scott that the yield differentials are very meaningful. Still I assume that they are a bit distorted. They might be even bigger without the ECB interventions. I assume Scott might say that’s exactly the point of monetary policy, dummy. So I might say, yes, but maybe Italy’s problems are mostly structural, so maybe the “distortions” are really distortions; a cosmetic surgery that just glosses over the structural problems for a while until the S hits the F.

In which regard one can note the USA has defaulted on its bonds twice by redenominating them in its own fiat currency substituted for promised gold. The latter instance was FDR, of course. The earlier is an interesting story, ending in the Legal Tender Cases of 1871.

During the Civil War Lincoln ordered the government to print “greenbacks” to pay war costs. His Secretary of the Treasury, Salmon P. Chase, objected that paper fiat money was unconstitutional, as it plainly was in the understanding of the day. Lincoln famously replied “I have the Constitution in my desk” and told him to do it. The war passed and afterwards the US started redeeming maturing pre-war bonds by paying them off with greenbacks. The bondholders objected that they had been promised payment in gold money and the case went to the Supreme Court.

The Chief Justice now was Salmon P. Chase and the Court ruled for the bondholders saying the Constitution required the bonds to be paid off with gold money (Hepburn v. Griswold). On the same day that the decision was announced President Grant appointed two new Justices to the Court who promptly voted to reconsider and then became the swing voters in reversing. Grant succeeded in “packing the court” as FDR only dreamt of, and fiat money became constitutional. Though to his dying day Grant insisted that his making those two appointments was pure coincidence.

The legal side of FDR’s default is important and interesting too, and is hugely neglected. After their encounter with Grant bond investors said “Fool me once…” and US bonds thereafter included explicit terms requiring them to be paid in gold whatever the USA did with its currency. When FDR refused anyhow and the case went to the Supreme Court the Justices were appalled, some writing privately that they would never buy US bonds again.

FDR made clear he was going to steamroll the Court. He wrote a speech (which still exists) telling the public it had to be ignored. With his and the Democrats’ standing in 1933 he would have rolled over it no doubt, the court as we know it would have been destroyed, no more constitutional review of New Deal programs, it would have become like the Supreme Court of Argentina.

Five Justices wrote opinions calling FDR’s act “default”, but Chief Justice Hughes (an astute politician, former Secretary of State and governor or New York) saved the Court by keeping those opinions separate and writing a deciding one that’s been described by scholars as “one of the most baffling ever issued” in which he resorted to the dodge ‘the plaintiffs have a right but no remedy’ in a great number of wordy words. As a result the Court continued to function, ruled FDR’s NRA unconstitutional, when FDR later tried to pack it he was politically weaker and it blew back on him … For the story see:

Of course in 1933 the US had plenty of gold to pay off the bonds. FDR easily could have paid off the bonds by their terms while changing the gold-dollar ratio for other purposes or even going fiat. It was politics. Defaults always are, fiat money or no. (Sorry MMTers.)

This is all a digression, I guess — but there are significant lessons in it about how the Constitution really works, even unto the days of Trump.

GV, I don’t think that would count as default, because bonds no longer had a gold clause. Whether it was redenomination is sort of in the eye of the beholder. Gold was much less central to the monetary regime than before 1933.

No, I think deficits are more likely to boost rates, albeit not very much. Yes, deficits tend to rise during recessions, when rates are falling. But I think rates are falling in recessions for reasons other than the deficits.

So is monetisation a default? BoJ? After all, investors were promised to be paid back in a stable currency, not a worthless currency. I guess that depends on your definition.

Political risk related to leaving the single currency (re-denomination) and thus the EU is not the same as plain default risk. Hence you will read in financial press about re-denomination risk and a default risk. They are not the same since they involve different scenarios and different complementary risks.

Christian has still not explained to us how evenly limited ECB purchases affect the interest rate spreads. Other than proper monetary policy preventing a total collapse of the Eurozone economy and its breakup, which is however not a first round effect. Italy would not be in trouble had ECB done its job properly. That is not to say Italy has no structural issues but the fact is that 20 years prior to the recession Italian productivity was growing almost as fast as German and it was just marginally lower than in Germany. Unemployment used to be lower in Italy than in Germany. Apparently most of the disaster in Italy is a matter of monetary policy which induced uncertainty and political risks.

I would say if Euro survives the Italian elections, it will stay here for decades to come and new members will join. EURUSD will gradually return back to 1.5+ If Italy bugs off, there will be a massive turmoil in Europe, perhaps another global recession and financial crisis.

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.